SAMARA UNIVERSITY

COLLEGE OF BUSINESS AND ECONOMICS

DEPARTMENT OF ECONOMICS

DETERMINATS OF BANK PROFITABILITY: IN CASE OF

COMMERCIAL BANK OF ETHIOPIA BRANCH OF WADERA

A RESEARCH PROPOSAL SUBMITTED TO THE DEPARTMENT OF

ECONOMICS IN PARTIAL FULFILLMENT FOR THE
REQUIREMENT OF BA DEGREE IN ECONOMICS

BY:-ADISU UTURA

ADVISOR:EBRAHIM MSGANAW (MSc)

JANUARY, 2015

SAMARA, ETHIOPIA
 Table of content

Contents
Table of content...........................................................................................................................................................I
CHAPTER ONE.........................................................................................................................................................1
1. INTRODUCTION..................................................................................................................................................1
1.1. Background of the study..................................................................................................................................1
1.2. Statement of the problem.................................................................................................................................3
1.3. Objective of the study......................................................................................................................................4
1.4. Hypothesis.......................................................................................................................................................5
1.5. Significance of the study.................................................................................................................................5
1.6. Scope of the study............................................................................................................................................6
1.7. Limitation of the study.....................................................................................................................................6
1.8. Conceptual framework.....................................................................................................................................6
1.9. Organization of the paper................................................................................................................................7
CHAPTER TWO........................................................................................................................................................7
2. LITERATURE REVIEW.......................................................................................................................................7
2.1. Theoretical findings.........................................................................................................................................7
2.2. Measure of bank profitability...........................................................................................................................8
2.3. Determinants of bank profitability and variable selection................................................................................9
2.3.1. Dependent variables..................................................................................................................................9
2.3.2. Independent variables: Determinants of bank profitability.......................................................................9
2.4 Empirical Findings.........................................................................................................................................12
2.5 Summary........................................................................................................................................................15
CHAPTER THREE..................................................................................................................................................15
3. METHODOLOGY...............................................................................................................................................15
3.1. Research Design............................................................................................................................................15
3.2. Data Source...................................................................................................................................................16
3.3. Data Analysis.................................................................................................................................................16

I
 3.3.1. Descriptive statistics...............................................................................................................................16
3.3.2. Description and measurements of variables............................................................................................17
4.Time and Budget Plan.......................................................................................................................................18
4.1. Time plan.......................................................................................................................................................18
4.2. Budget plan................................................................................................................................................２０
REFERENCES.....................................................................................................................................................２１

1.4. Hypothesis.......................................................................................................................................................4
1.5. Significance of the study..................................................................................................................................5
1.6. Scope of the study............................................................................................................................................5
1.7. Limitation of the study.....................................................................................................................................5
1.8. Conceptual framework.....................................................................................................................................5
1.9. Organization of the paper.................................................................................................................................6
CHAPTER TWO........................................................................................................................................................7
2. LITERATURE REVIEW.......................................................................................................................................7
2.1. Theoretical findings.........................................................................................................................................7
2.2. Measure of bank profitability...........................................................................................................................8
2.3. Determinants of bank profitability and variable selection................................................................................8
2.3.1. Dependent variables..................................................................................................................................8
2.3.2. Independent variables: Determinants of bank profitability........................................................................9
2.3.2.1. Bank-specific determinants................................................................................................................9
2.3.2.2. Macro Variables...............................................................................................................................10
2.4 Empirical Findings..........................................................................................................................................11
2.5 Summary.........................................................................................................................................................14
CHAPTER THREE..................................................................................................................................................15
3. METHODOLOGY...............................................................................................................................................15
3.1. Research Design............................................................................................................................................15
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 3.2. Data Source....................................................................................................................................................15
3.3. Data Analysis.................................................................................................................................................15
3.3.1. Descriptive statistics...............................................................................................................................16
3.3.2. Description and measurements of variables............................................................................................16
3.3.2.1 Dependent variables..........................................................................................................................16
3.4.2.2. Independent variables.......................................................................................................................17
4.Time and Budget Plan.......................................................................................................................................18
4.1. Time plan.......................................................................................................................................................18
4.2. Budget plan................................................................................................................................................２０
REFERENCES.....................................................................................................................................................２１

III
 CHAPTER ONE

1. INTRODUCTION

1.1. Background of the study

The banking sector acts as the life blood of modern trade and commerce to provide them with a major
source of finance. This increasing phenomenon of globalization has made the concept of efficiency more
important both for non-financial and financial institutions and banks are the part of them.

The banking sector is essential of the Ethiopian economy and plays an important financial intermediary
role; therefore, its health is very critical to the health of the general economy at large. In the last twenty
years there has been a rapid increase in the activity of private banks in Ethiopia, and this has fostered
rapid competitiveness among banks in Ethiopia. In our increasing world of business and finance, the task
of each bank operating to make more profit is becoming a challenge with each passing day. In order for
an organization like CBE to operate optimally, it has to be able to measure its profitability with regards to
its inputs and outputs.

The study of profits is important not only because of the information it provides about the health of the
economy in any given year, but also because profits are a key determinant of growth and employment in
the medium-term. Changes in profitability are an important contributor to economic progress via the
influence profits have on the investment and savings decisions of companies. This is because a rise in
profits improves the cash flow position of companies and offers greater flexibility in the source of finance
for corporate investment (i.e. through retained earnings). Easier access to finance facilitates greater
investment which boosts productivity, productive capacity, competitiveness and employment.

The existence, growth and survival of a business organization mostly depend upon the profit which an
organization is able to earn. It is true that when Profitability increases the value of shareholders may
increase to considerable extent.

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The term profitability refers to the ability of the business organization to maintain its profit year after
year. The profitability of the organization will definitely contribute to the economic development of the
nation by way of providing additional employment and tax revenue to government exchequer. Moreover,
it will contribute the income of the investors by having a higher dividend and thereby improve the
standard of living of the people.

Like all businesses, banks profit by earning more money than what they in expenses. The major portion
of a bank’s profit comes from the fees that it charges for its services and the interest that it earns on its
assets. Its major expense is the interest paid on its liabilities. The major assets of a bank are its loans to
individuals, businesses, and other organizations and the securities that it holds, while its major liabilities
are its deposits and the money that it borrows, either from other banks or by selling commercial paper in
the money market.

The determinants of profitability are empirically well explored although the definition of profitability
various among studies. Disregarding the profitability measures, most of the banking studies have noticed
that the capital ratio, loan-loss provisions and expense control are important drivers of high profitability.
Determinants of bank profitability can be split between those that are internal and those that are external.

The internal determinants of bank profitability can be defined as those factors that are influenced by the
bank’s management decisions and policy objectives. Management effects are the results of differences in
bank management objectives, policies, decisions, and actions reflected in differences in bank operating
results, including profitability.

The external determinants are variables that are not related to bank management but reflect the
economic and legal environment that affects the profitability of banks. Athanasoglou et al, (2006) stated
that the importance of banks is more pronounced in developing countries because financial markets are
usually underdeveloped, and banks are typically the only major source of finance for the majority of firms
and usually the main depository of economic savings. Thus, this study focuses on the determinants
profitability of Commercial Bank of Ethiopia.

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1.2. Statement of the problem
To understand how well a bank is doing, it needs to start by looking at a bank’s income statement, the
description of the source of income and expenses that affect the bank’s profit.

The banking industry in general has experienced some profound changes in recent decades, as
innovations in technology and the inexorable forces driving globalization continue to create both
opportunities for growth and challenges for banking managers to remain profitable in this increasingly
competitive environment,(Athanasoglou et al,2006).

The very nature of the banking business is so sensitive because more than 85% of their liability is
deposits from depositors (Saunders and Cornett, 2008). Banks use these deposits to generate credit for
their borrowers, which in fact is a revenue generating activity for most banks. This credit creation process
exposes the banks to high default risk which might led to financial distress including bankruptcy.

Commercial banks in Ethiopia have over the years depended very much on increasing lending rates in
order to maximize profits, without much regard to the efficient use of resources that could be result in
cost minimization. Thus, the performance of commercial banks should be measured in respect of total
assets, loans, non-interest income, total overhead expenses, and book values of stockholder’s equity.

Whereas commercial bank of Ethiopia is not in a position to increase its lending rate to maximize profit
because the bank has a social responsibility to play its macroeconomic role in stabilizing the economy of
the country. Commercial bank of Ethiopia needs to appreciate the role of other indicators in enhancing
the profitability for the matter. Indeed examining the determinants of commercial bank’s profitability is
crucial, if this bank is going to remain competitive, efficient, and viable taking into cognizance the
challenges that befall competition in the industry.

This thesis builds on earlier research of Pasiouras and Kosmidou (2007), Athanasoglou et al. (2008) and
Dietrich and Wanzenried (2011), which incorporate macroeconomic, industry – specific and bank –
specific determinants of profitability, Habtamu(2012), which focused on the factors affecting banks
profitability in Ethiopian private commercial banks.

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This thesis extents prior research presented here, in three ways. First, the empirical part of the current
research uses data over the last decade for the Ethiopian banking sector, second this thesis aims to extend
the determinants of bank’s profitability by examining ROA. Third, this thesis attempt to generalize results
found by Habtamu(2012) to the state commercial banking sector.

In recent time the profit of Commercial bank of Ethiopia is increasing dramatically. So which category of
profit drivers is key explaining profitability of commercial bank of Ethiopia?

1.3. Objective of the study

The main objective of this study is to provide a framework to investigate the factors or indicators
intrinsic in the bank’s asset structure that had impacted on their profitability, and performance for
that matter, and make policy recommendation that could be used by bank managers in their policy
decisions in the future. Other specific objectives the study seeks are:
 To examine the profitability of CBE during the last one decade,


 To examine the key endogenous or company-level value drivers of performance or

profitability of Ethiopian banks using CBE,
 To examine the key exogenous or macro-economic value drivers of performance or
profitability of Ethiopian banks using CBE,
 To find out if any long-run or short-run relationship exists between Profitability variables and
its determinants using CBE, and
 Make policy recommendations regarding the key drivers of profitability at CBE as well as other
commercial banks in the country based on the empirical findings.
 Objectives of the Study
1.3.1 General Objective
The major objective of the study is to examine factors that determined commercial bank
profitability in Ethiopia
1.3.2 Specific Objectives
More specifically, the study attempt to:
1. To explores the major internal factors that determine the commercial banks profitability in
Ethiopia;
2. To evaluate the effect of macroeconomic (external factors) on the profitability of

4
 commercial banks in Ethiopia;
3. To identify the relationship between independent variables and dependent variables and;
4. To realize which bank profitability theory best explains the finding of this research;
1.3.3 Research questions
Based on the objectives, the research provides answer for the following research questions:
1. What are the internal factors that determine the profitability of commercial bank in
Ethiopia?
2. Which macroeconomic factor affects commercial banks’ profitability?
3. How does bank size affect commercial banks’ profitability?
4. What is the relationship between loan to deposit ratio and profitability?
5. What is the effect of liquidity risk on commercial banks’ profitability?
6. What is the relationship between funding cost and profitability?
7. What is the relationship between management Efficiency and profitability?
8. What is the relationship between inflation and profitability?
9. How does GDP affect commercial banks’ profitability?
10. What is the relationship between eexchange rate and profitabilit

1.4. Hypothesis

The study were developed the following hypotheses:

 H10: The independent variables in the model are significant.

 H20: The explanatory variables are independent (test for multicollinearity)

1.5. Significance of the study

The banking industry is crucial source of financing different business segments that is operated in a given
country. Due to these facts, this study will help the banks to;

 Identify the determinants of profitability by examining the findings and recommendations.

5
  The study will initiate other bank services providers to give due emphasis on the management of
identified variables.
 The study will also provide bank managers with understanding of activities that would enhance
their banks profitability.

Furthermore, other interested researchers may take this study as a base for detailed and further studies.

1.6. Scope of the study

In Ethiopia at this time there are around eighteen banks under operation and some banks are under the
pipeline. From the number of banks under operation the study uses the Commercial Bank of Ethiopia as a
case study.

1.7. Limitation of the study

The first limitation of the study is private owned banks are not considered. Therefore, the study does not
reflect the overall picture of profitability of the banking industry in Ethiopia. Secondly, in relation to data
analysis, less number of observation is considered in the econometrics model. In addition to the above
factors data limitation and research sample limitation are the other sides to the limitation part of the study.

1.8. Conceptual framework

Different empirical evidences suggested that profitability of financial institutions specifically banks is
affected by internal and external factors. This study used both internal and external determinants of bank
profitability includes credit risk, managerial efficiency, liquidity, bank size, level of GDP, and inflation.
The study has seen how these variables are determined the profitability of Commercial Bank of Ethiopia
within the last decade.

6
1.9. Organization of the paper

The rest of this paper will organize as follows: Chapter two presents empirical and theoretical review of
the literature related to the issue of determinants of bank profitability; Chapter three provides research
design and methodology employed in the analysis of the data; Chapter four contains results and
discussion; and Chapter five gives summary, conclusion and recommendations. A “Reference” of related
literature is referred while writing the paper.

7
 CHAPTER TWO

2. LITERATURE REVIEW

2.1. Theoretical findings

In principle a bank’s capacity to absorb unforeseen losses determines its level of risk (Goddard et al.,
2004). Several ratios are commonly used to proxy for risk, including the capital account ratio (CAR) and
the liquidity ratio. In theory an excessively high CAR could signify that a bank is operating over-
cautiously and ignoring potentially profitable investment opportunities. A bank holding a relatively high
proportion of liquid assets is unlikely to earn high profits, but is also less exposed to risk; therefore
shareholders should be willing to accept a lower return on equity (Goddard et al., 2004).

Banks in countries with a more competitive banking sector where banking assets constitute a larger share
of GDP – have smaller margins and are less profitable. The bank concentration ratio also affects bank
profitability; larger banks tend to have higher margins. Well – capitalized banks have higher net interest
margins and are more profitable. This is consistent with the fact that banks with higher capital ratios have
a lower cost of funding because of lower prospective bankruptcy costs (Demirgüç-Kunt et al, 1999).

Differences in a bank’s activity mix affect spread and profitability. Banks with relatively high non interest
– earning assets are less profitable. Also, banks that rely largely on deposits for their funding are less
profitable, as deposits require more branching and other expenses. Similarly, variations in overhead and
other operating costs are reflected in variations in bank interest margins, as banks pass their operating
costs (including the corporate tax burden) on to their depositors and lenders. Macroeconomic factors also
explain variation in interest margins.

Inflation is associated with higher realized interest margins and greater profitability. Inflation brings
higher costs – more transactions and generally more extensive branch networks – and also more income
from bank float. Bank income increases more with inflation than bank costs do (Demirgüç-Kunt et al,
1999).

8
2.2. Measure of bank profitability

Measuring bank performance is a lot like measuring the performance of a traditional company. A bank’s
revenue is the return it makes from investments, and this income comes from interest or asset
appreciation on investments, such as stocks or estate. Banks must also consider the cost of the funds used
to make these investments. Profits are ultimately made from the spread between the amount banks pay for
the investment and the amount they receive from borrowers. The most commonly used measure of profit
for bank is referred to as net interest margin (Goddard et al., 2004).Although net income gives us an idea
of how well a bank is doing, it suffers from major drawback. It does not adjust for the bank’s size, thus
making it hard to compare how well one bank is doing relative to another. A basic measure of bank
profitability that corrects for the size of the bank is the return on asset (ROA) which divides the net
income of the bank by the amount of its assets. ROA is a useful measure of how well a bank manager is
doing on the job because it indicates that how well a bank’s assets are being used to generate profits
(Goddard et al., 2004).

2.3. Determinants of bank profitability and variable selection

In this section, both the dependent and independent variables that were selected for the analysis of bank
profitability.

2.3.1. Dependent variables

A basic measure of bank profitability that corrects for the size of bank is return on assets (ROA).
Different authors argue that return on equity and return on asset are used as a measure of bank
performance.

Javid et al. (2011) analyzed the determinants of top ten banks profitability in Pakistan over the period of
2004 to 2008. They focused on the internal factors only. They used the pooled ordinary least square
(POLS) method to investigate the impact of assets, loans, equity, and deposits on one of the major
profitability indicator of banks which is return on asset (ROA). This study intends to use return on assets
(ROA) as the dependent variable.

9
2.3.2. Independent variables: Determinants of bank profitability
This section describes the independent variables used in the study to analyze bank profitability. This
includes internal factors (bank-specific) and external factors (macroeconomic) that determine bank
profitability.

2.3.2.1. Bank-specific determinants

As internal determinants of bank profitability, the researcher used among the following bank-specific
variables:

Credit risk: The ratio of loan loss provisions over total loans is a measure of a bank’s credit quality. The
loan loss provisions are reported on a bank’s income statement. A higher ratio indicates a lower credit
quality and, therefore, a lower profitability. Thus, the researcher expects a negative effect of the loan loss
provisions relative to total loans on bank profitability.

Deposit to total asset: It can measure a bank’s growth by the annual growth of its deposits. One might
expect that a faster growing bank would be able to expand its business and thus generate greater profits.
However, the contribution of an increasing amount of deposits to the profit depends upon a number of
factors. First, it depends on the bank’s ability to convert deposit liabilities into income earning assets. It
also depends on the credit quality of those assets. Growth is often achieved by investing in assets of lower
credit quality, which has a negative effect on bank profitability. In addition, high growth rates might also
attract additional competitors. This again reduces the profits for all market participants. Therefore, the
sign of this variable is either positive or negative.

Bank size: it can be measured by total assets. One of the most important questions in the literature is
which bank size maximizes bank profitability. For example, both Smirlock,M.(1985),and Pasiouras and
Kosmidou (2007) argue that a growing bank size is positively related to bank profitability. This is
because larger banks are likely to have a higher degree of product and loan diversification than smaller
banks, which reduces risk, and because economies of scale can arise from a larger size.

10
Because reduced risk and economies of scale lead to increased operational efficiency, so it is expected
that a larger size to have a positive effect on bank profitability, at least up to a certain point.

Total loan to total asset: used as a measure of liquidity risk is another type of risk for banks; when banks
hold a lower amount of liquid assets they are more vulnerable to large deposit withdrawals. Therefore,
liquidity risk is estimated by the ratio of liquid assets to customer deposits and other short term funding.
Based on the risk-return hypothesis, more liquidity risk is associated with higher expected returns.
Otherwise stated more cash and other liquid non-earning assets result in a lower expected return because
these assets do not generate any return. Following prior research of Pasiouras and Kosmidou (2007) and
Santabárbara D et al. (2009) a negative relationship for liquid assets to customer deposits and short term
funding is hypothesized.

Non-interest income: To recognize that financial institutions in recent years have increasingly been
generating income from ―off-balance sheet business and fee income general, the ratio of non-interest
income over total assets (NII/TA) is entered in the regression analysis as a proxy for non-traditional
activities. Non-interest income consists of commission, service charges, and fees, guarantee fees, net
profit from sale of investment securities, and foreign exchange profit. The ratio is also included in the
regression model as a proxy measure of bank diversification into non-traditional activities. The variable
is expected to exhibit positive relationship with bank profitability (García-Herreroet al., 2009).

Managerial efficiency: the ratio of TOE/TA is used to provide information on the variations of bank
operating costs. The variable represents the total amount of wages and salaries as well as the costs of
running branch office facilities. The relationship between the TOE/TA variable and profitability levels
may be negative, as banks that are more productive and efficient aim to minimize their operating costs.
Furthermore, the usage of new electronic technology, like ATMs and other automated means of
delivering services may have caused wage expenses to fall as capital is substituted for labor (Sufian,F.,
2011).

11
2.3.2.2. Macro Variables

Real GDP growth: Real GDP growth in percentage was examined because it is a proxy of the business
cycle in which banks operate. Hereby this variable controls for variance in profitability due to differences
in business cycles between countries. According to Demirgüç-Kunt et al. (1999), Athanasoglou et al.
(2008) and Dietrich et al. (2011) the business cycle, with its up and downswings, influence the demand
for borrowing. Following Athanasoglou et al. (2008) cyclical downswings decrease the demand for
borrowing and credit risk will increase due to uncertainty and volatility in the markets. Accordingly,
during cyclical downswings the loan quality deteriorates and provision for non-repayments increase,
lowering banks’ profitability. Hence, a positive relationship between real GDP growth and profitability is
expected. In contrary to García-Herrero, et al., (2009) inflation is not separately examined as the real
GDP growth captures inflation in the denominator.

In the case of the external variables, bank‘s profitability is sensitive to macroeconomic conditions despite
the trend in the industry towards greater geographic diversification and a larger use of financial
engineering techniques to manage risk associated with business cycle forecasting. Generally, higher
economic growth encourages banks to lend more and permits them to charge higher margins while
improving the quality of their assets. Dermiguc-Kuntet al. (2001) and Bikker and Hu (2002) identify
possible cyclical movements in bank profitability, i.e., the extent to which bank profits are correlated with
the business cycle. Their findings suggest that such a correlation exists, although the variables used were
not direct measures of the business cycle (Sufian,F., 2011). It is based on the above arguments that these
variables will be considered; (GDP) and (annual inflation rate).

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2.4 Empirical Findings
As per Dietrich,A & Wanzenried,G.(2011),the coefficient on GDP per capita indicates that banks in
higher per capita income countries are more efficient in terms of attracting more deposits and generating
stronger cash flows than banks in low income countries. This should not be surprising as countries with
higher per capita income (i.e., more developed countries) tend to generate more savings, and hence more
deposits. Concerning other elements of the macro environment, their findings on the effect (or precisely
lack thereof) of macro financial structure are no effect of macro financial structure on commercial bank
performance. An interesting point to note in this regard is that unlike the experience of some countries
(notably in Latin America), high inflation is not necessarily associated with large-scale inefficiencies,
which could take the form of price- and non-price behavior, as hypothesized earlier. The findings that
credit risk have a positive and significant effect on profitability. This suggests that risk-averse
shareholders target risk adjusted returns and seek larger earnings to compensate higher credit risk.
Macroeconomic variables significantly affect bank profitability in Africa. In particular, inflation has a
positive effect on bank profits, which suggest that banks forecast future changes in inflation correctly and
promptly enough to adjust interest rates and margins (ibid).

The provision to total loans ratio is found to have a significant negative impact on banks’ return on assets.
Though banks tend to be more profitable when they are able to undertake more lending activities, yet due
to the credit quality of lending portfolios and the general practice in Macao, a higher level of provision is
needed. Such a high level of provisions against total loans in fact depresses banks’ return on assets
significantly. The negative sign on bank size suggests that larger banks achieve a lower ROA than smaller
ones. This shows that the interbank market is competitive and efficient since banks with a large retail
deposit-taking network do not necessarily enjoy a cost advantage against other banks. Therefore, rather
than size, efficiency is more important in affecting bank profitability. Among the external determinants,
only the inflation rate shows the strongest impact on banks’ return on assets. This may imply that bank
management may anticipate the rate of inflation and react accordingly. Consequently, banks in Macao
tend to be more profitable in inflationary environments. As for the economic growth show no impact on
bank profitability (Heffernan, S et al., 2008).

13
As per Rasiah,D.(2010),interestingly, however, deposit growth (DG) has a negative relationship with both
ROA and ROE; the relationship is not only consistent across different methods but also statistically
significant in four of the six regressions (table 3). The results appear to indicate that while deposit
financing may be an important determinant of profitability, some institutions may have reached their
optimum deposit–asset ratios and those seeking to expand their deposit base assertively, with the
intention of eventually improving profitability, may have to do so at the cost of rising expenses and
falling profitability in the meantime. Moreover, institutions may not be able to convert high growth in
deposits into high income generating assets; due perhaps to lack of bankable projects (ADB, 2005).

As to Saunders et al (2000), the yearly growth of deposits does not significantly affect bank profitability.
There is no empirical evidence that banks in Switzerland are able to convert an increasing amount of
deposit liabilities into significantly higher income earning assets. As to bank size some empirical
evidence that larger commercial banks were slightly less profitable than medium-sized banks. The loan
loss provision relative to total loans ratio, which is a measure of credit quality, does not have a
statistically significant effect on bank profitability before the crisis. Unsurprisingly and most
interestingly, the loan loss provisions, which have also significantly increased during the crisis, negatively
affect profitability measure in the period of the crisis. The GDP growth rate does not affect bank
profitability in Switzerland.

According to Santabárbara D et al. (2009) Loan loss provision ratio, Liquidity of assets ratio and
Overheads ratio have negative correlation. Whereas size has positive correlation confirms the general
accepted idea that bigger banks obtain better results.

Dietrich, A & Wanzenried,G.(2011)find that credit risk has a positive and significant effect on
profitability. This suggests that risk-averse shareholders target risk adjusted returns and see larger
earnings to compensate higher credit risk. The positive and significant coefficient of the size variable
gives support to the economies of scale market-power hypothesis. Larger banks make efficiency gains
that can be captured as higher earnings due to the fact that they do not operate in very competitive
markets.

14
The macroeconomic variables significantly affect bank profitability in Africa. In particular, inflation and
GDP growth has a positive effect on bank profits. The provision to total loans ratio is found to have a
significant negative impact on banks’ return on assets. As discussed in the literature, asset quality is
reflected in the ratio. Though banks tend to be more profitable when they are able to undertake more
lending activities, yet due to the credit quality of lending portfolios and the general practice in Macao, a
higher level of provision is needed. Such a high level of provisions against total loans in fact depresses
banks’ return on assets significantly. In addition to the above characteristics, the negative sign on market
share suggests that larger banks achieve a lower ROA than smaller ones. This shows that the interbank
market is competitive and efficient since banks with a large retail deposit-taking network do not
necessarily enjoy a cost advantage against other banks. Therefore, rather than size, efficiency is more
important in affecting bank profitability. Among the external determinants, only the inflation rate shows
the strongest impact on banks’ return on assets. This may imply that bank management may anticipate the
rate of inflation and react accordingly. Consequently, banks in Macao tend to be more profitable in
inflationary environments. As for the other variables, namely economic growth, have no impact on bank
profitability (Dietrich et al., (2011).Among the internal determinants, the asset quality and market share
variables show a significant impact on bank profitability. As for the loan-to-total assets ratio rather than
affecting profitability positively, it actually reduces the return on assets (James and José 2011).

2.5 Summary

Prior research emphasized the influence of regulation and ownership structure on risk taking and
profitability of banks. Research towards the impact of ownership structure on risk taking and performance
in the banking sector, is initiated by Saunders et al. (1990). They find that banks with shareholder

15
ownership and stock option compensation, take significantly more risk than shareholder owned banks in
which managers do not receive any stock option compensation. Other studies try to validate this
relationship but findings are mixed depending on sample period and region (Goddard et al., 2007 and
Ayadi et al., 2010). Furthermore, Laeven& Levine (2009) incorporate the effects of regulation and find
that regulation has different effects on bank risk taking depending on the ownership structure.

CHAPTER THREE

3. METHODOLOGY

3.1. Research Design

The main objective of this study is to investigate the determinants of profitability of Commercial bank of
Ethiopia. This research paper employed quantitative research design. Quantitative research involves
counting and measuring of events and performing the statistical analysis of a body of numerical data. The
main concern of quantitative paradigm is that measurement is reliable, valid, and generalized in its cause
and effect (Cassell and Symon, 1994).

3.2. Data Source

The research paper will employ data from secondary sources. Mainly, annual reports of the Commercial
bank of Ethiopia over the period, 2003 – 2015 on the total assets, loans, total non-interest income, total
loan loss provisions, total operating expenses will be used to estimate the ratios and coefficients for the
internal determinants.

For external determinants, data on gross domestic product (GDP) and inflation were obtained from the
central statistics authority (CSA) over the period 2003-2013.

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3.3. Data Analysis
For data analysis purpose, ordinary least square (OLS) method were used to investigate the impact of
independent variables on major profitability indicators. i.e., return on asset (ROA) separately.

Regression analysis were carried out to test hypotheses to find which independent variable(s) individually
and collectively provide a meaningful contribution towards the explanation of the dependent variable
noted that if an investigation wishes to determine whether some conceptually measures add anything to
the dependent variable. Additionally, STATA and MS Excel were also used to carry out calculations in
some cases as STATA provides in-depth investigation in data analysis and visualization.

3.3.1. Descriptive statistics

Mean, minimum, maximum and standard deviation values are used to analyze the general trends of the
data from 2003 to 2012 for the variables which included in the study. A correlation matrix was used to
examine the relationship between the dependent variable and explanatory variables to investigate
multicolinarity problem between variables.

3.3.2. Description and measurements of variables

According to Creswell (2009), the variables need to be specified in quantitative researches so that it is
clear to readers what groups are receiving the experimental treatment and what outcomes are being
measured. Bank profitability is usually measured by the return on average assets, return on equity, and net
interest margin which are expressed as a function of internal and external determinants. From those
variables the researcher used ROA as a best profitability measure. The internal determinants include
bank-specific variables. The external variables reflect environmental variables that are expected to affect
the profitability of banks. In this paper both internal and external variables are used to investigate the
determinants of private commercial banks profitability.

17
3.3.2.1 Dependent variables

Bank profitability will be measure by the ratio of the Return on Average Assets (ROA). The profitability
measure used in the study described as follows;

Return on Asset (ROA)

As Golin (2001) points out, the ROA has emerged as key ratio for the evaluation of bank profitability and has
become the most common measure of bank profitability. The following authors also used ROA as a measure
of bank profitability (Yuqi Li (2006), Abebaw and Depaack (2011), Berger (1995), Indranarain Ramlall
(2009), Imad et al. (2011), Tobias and Themba (2011), Belayneh (2011), and Athanasoglou et al. (2008)). The
ROA reflects the ability of a bank’s management to generate profits from the bank’s assets.

It shows the profits earned per birr of assets and indicates how effectively the bank’s assets are managed
to generate revenues, although it might be biased due to off-balance-sheet activities. Average assets were
used in this study, in order to capture any differences that occurred in assets during the fiscal year.

ROA can be calculated as:

Return on asset (ROA) = Net profit after tax/ Average total assets

This is probably the most important single ratio in comparing the efficiency and operating performance of
banks as it indicates the returns generated from the assets that bank owns.

3.4.2.2. Independent variables

This paper will use the major dimensions of bank’s operation: bank size, managerial efficiency, liquidity,
credit risk, inflation, and Real GDP. These variables can be measured in the formula;

 Bank size: natural logarithm of total of the bank.

 Managerial efficiency: the ratio of operating expense to operating income was used and the higher
the ratio the lower the managerial efficiency.

Managerial efficiency = Operating expense/ Operating Income

18
  Liquidity: the ratio of total loans to total deposits was applied to find this variable.

Liquidity = Total loan/ Total deposit

 Credit risk: the ratio of loan loss provision to total loan.

Credit risk = LLP/ TL

 Inflation: the yearly annual inflation rate was used.

 Real GDP: the yearly real gross domestic product (GDP) growth rate was used.

4.Time and Budget Plan

4.1. Time plan

Activity December Januar February March April May June

y
No

Topic Xx

selection
1

Preparation Xx

of proposal
2

3 Submission xx

of proposal

19
 Collection of xx

useful
3
material

5 Data xx Xx

collection

Data Xx

analysis and
6
writing of
final
research

7 Submission Xx

of research

Presentation xx

of final
research
8

20
4.2. Budget plan

Item Quantity Per unit (Birr) Total Cost (Birr)

Equipment Paper 1 ream 300.00 300.00

and
Pens 3 20.00 60.00
stationary
Pencil 3 5.00 15.00

Total Cost - - 375.00

Personal Transportation 2 trips 800.00 1600.00

cost
Internet 250 min. 0.20 50.00

Printer 45pages 5 225.00

- - 1,875

Total cost

Contingency - - 250.00

Overall total cost - - 2,500

21
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